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Swap arrangements with financial futures contracts to manage risk

Assess the benefits and costs of using swap arrangements with financial futures contracts as a tool for managing the companies risk.

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The problem wants you to understand what a swap arrangement is and how it helps a company to reduce risk. Swap arrangement means that the company enters into two transactions today one for buying and one for selling at the futures rates available today. The purpose is that if there is a fluctuation in the price in future then the profit cancels out the loss and the net result is that the company manages to get its deal without undue loss or profit from market fluctuation. Consider the following example. A company is starting a project now, which will take four years to complete; it needs a loan of one billion dollars at the end of one year. However it has to complete its tender form today and determine the cost of the project today. Now during the course of two years interest rates may fluctuate and either lead to unexpected profits or unexpected losses. The company is not in the business of ...